KiwiSaver reforms could prevent risk of retirement shortfalls

William Townsend suggests behavioural nudges and design changes for the more than 15 percent of KiwiSavers who remain in default conservative funds.

Traditional neoclassical economics assumes individuals are rational, self-interested and utility maximising. Behavioural economics, on the other hand, takes a more realistic view of behaviour based on evidence that human beings are fallible, easily confused in complex scenarios, unable to calculate risk accurately and more irrational than neoclassical theory would suggest.

Behavioural economics has a great deal to offer in considering how New Zealand’s national retirement savings scheme, KiwiSaver, could be improved.

After more than 10 years, KiwiSaver has over 2.8 million members and has become a permanent feature of New Zealand’s financial services sector. As of March 2018, however, 431,779 KiwiSaver members (15.2 percent of total membership) remained in the default conservative fund into which they were automatically enrolled.

Collectively, these funds held over $4.6 billion in assets in 2018, with just under half the default members (201,322) not actively contributing. This number of default members has remained consistently high over time and there is growing concern default fund members are missing out on potential retirement savings as a result.

KiwiSaver is delivered by private scheme providers (around 30 in 2018), with working individuals making contributions from pay-checks at 3 percent, 4 percent or 8 percent and employers contributing a minimum of 3 percent.

In June 2018, the Taxation (Annual Rates for 2018–19, Modernising Tax Administration, and Remedial Matters) Bill was introduced into Parliament: it provides for additional contribution rates of 6 percent and 10 percent and limits the length of contributions holidays to one year.

Upon beginning employment for the first time or beginning new employment, a KS2 KiwiSaver deduction form must be completed by employees so they can be automatically enrolled or their contribution rate updated.

Critically, the form does not allow a fund choice if the individual is being automatically enrolled (as there is only one default fund type) and only requires a contribution rate selection. This means even those automatically enrolled members who wish to select their preferred fund are unable to do so.

Default members are automatically and randomly allocated into one of the nine government-appointed default provider funds, with a default contribution rate of 3 percent unless a different rate is consciously selected.

KiwiSaver’s automatic allocation system into a default fund and contribution rate was chosen in light of evidence suggesting that in domains where individuals have low financial literacy and less than perfect information default automatic enrolment produces considerably higher participation rates than voluntary enrolment.

The KiwiSaver default fund model was originally intended as a ‘temporary parking space’ from which default members would subsequently make a conscious fund choice.

As a result, a conservative investment approach (an allocation to growth-oriented investments of between 15 and 25 percent) was selected, with the assumption market forces would encourage members who would benefit from a more growth-oriented approach to switch funds.

The default funds are more conservative than the closest equivalent funds in Australia, Britain, Chile and Sweden.

As a result of the choice architecture of the default system, the expectation individuals would switch out of default funds failed to eventuate for a substantial number of individuals, many of whom are likely to be less financially literate and capable than those who made conscious fund choices. A significant proportion of these individuals have remained in these potentially inappropriate default funds for many years.

A number of behavioural biases (i.e. systematic patterns of deviation from rational human behaviour) appear to be influencing individuals to take and retain the default KiwiSaver fund and contribution rate:

Bounded rationality – where individuals fail to act and/or make rationally calculated savings decisions because of the inherent complexity involved and limits in cognitive capacity

Inertia/procrastination – where individuals suffer from inertia and procrastinate when considering, making and revisiting key savings decisions and tasks

Passive decision making – where individuals take the path or option of least resistance in savings and retirement savings plan decisions and tasks

Loss aversion – where individuals struggle to save more or move into a higher risk fund because they dislike potential losses more than they like potential gains

Framing effects – where individuals make or accept certain savings decisions because of how the selection or choice is framed

Present bias – where individuals struggle to save more or spend time considering savings decisions because they have limited self-control and willpower and prefer immediate gratification over future gains

Status quo bias and anchoring/pure endowment effect – where individuals become anchored to default funds and contribution rates as the status quo and treat them as a superlative endowment

Endorsement effect – where individuals select or passively take the default fund and contribution rate because of the conscious or unconscious interpretation that it is endorsed by the administrator or another authority, such as the government.

The KiwiSaver default funds’ low returns relative to more growth-orientated funds and low default contribution rate risk default members experiencing low household net worth, unsatisfactory retirement standards of living, an over-reliance on New Zealand Superannuation and government welfare, and a resulting low level of financial independence. This is in addition to the range of negative physical and psychological health impacts commonly associated with lower income households.

Around 330,000 default members have at least 15 years until retirement. For many of these individuals, the default conservative fund is likely to be inappropriate based on the length of time remaining until their retirement and the lower relative returns of the default funds.

One option for KiwiSaver might be using behavioural insights to use targeted communications to nudge default members to make conscious choices that will improve their retirement savings.

KiwiSaver providers, the Capital Markets Development Taskforce and the Prime Minister’s 2009 job summit have all voiced concern about the conservative default fund and argued for moving to a more growth-oriented default approach.

While any more growth-oriented alternative would offer greater returns for default members over time, research concluded that a target date default fund would provide the greatest potential return for default members, with one of the lowest risks of retirement savings shortfall.

A target date default fund would see the fund manager adjust investment risk and reduce growth asset allocation within the fund as the target retirement year approaches. With the current retirement age at 65, an individual born in 2000 and automatically enrolled in 2018 would enter a default fund with a target date of 2065.

Exposure to riskier growth investments would be adjusted downwards over time as 2065 approached (i.e. starting with a high proportion of growth-oriented assets and moving down to a low proportion).

A target date fund default system effectively mitigates the bounded rationality of individuals through simplifying complexity by not requiring a conscious choice from potentially uninformed or behaviourally biased investors at any point during their life. In this way, target date funds offer a simple to understand, ‘set and forget’ option.

Another improvement to retirement savings outcomes at minimal mental cost to members would be an automatically escalating KiwiSaver default contribution rate.

This would also avoid the possible negative impacts that statically increasing the mandatory minimum contribution rate may have on low-income savers.

As a behavioural nudge, auto-escalation would alter the choice architecture of the default contribution system so that an eligible member’s contribution rate automatically (with an opt-out) escalates in increments each year over time up to a set cap.

The automatic increase in contribution rates could, for example, be in 0.5 percent increments each year from 3 percent up to a maximum of 10 percent after 14 years. Even without a future increase to the employer contribution, combined savings rates for KiwiSaver members who don’t opt out could reach 13 percent of pay. This represents a substantial increase on the current 6 percent combined default rate that would raise KiwiSaver’s savings and preparedness for retirement considerably.

In the interests of New Zealanders’ futures, the concerns raised in this article should not go unheeded any longer.

This is an adapted version of an article in the latest issue of Policy Quarterly, published by the Institute for Governance and Policy Studies and School of Government at Victoria University of Wellington.

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